Cross border flows, with a bit of macroeconomics

David Dollar, Louis Kuijs and their colleagues have outdone themselves – and in the process provided a clear assessment of the sources of China’s current slowdown and the risks that lie ahead. I won’t try to summarize the entire report. Read it. The whole thing. No summary can do it justice.

Here though are seven points that jumped out at me.

1. China was no workers’ paradise during the boom years.

GDP growth has been quite strong. But wages have fallen from around 50% of China’s GDP at the start of the decade to around 40% of GDP. That – not a high rate of household savings – is the main reason why consumption is a very low share of GDP (See Figure 15 of the World Bank Quarterly). If China’s workers had secured a bigger share of China’s output, they could be better off now even if China had grown somewhat less rapidly. There is good reason to think that a world where China subsidies US borrowing (and consumption) isn’t the best of all possible worlds. The fruits of the recent boom weren’t shared broadly in either the capital-exporting countries or the capital-importing countries.

2. China really is a manufacturing and investment driven economy.

Even when compared to Korea in 1990 or Japan in 1980, China stands out. Investment accounts for a large share of GDP than it ever did for the smaller Asian miracles and manufacturing accounts for a higher share of China’s GDP than it ever did in other Asian manufacturing economies (Figure 14). Given China’s size, it is pretty clear that China cannot continue to grow by investing ever more and manufacturing ever more. China ultimately has to produce for Chinese demand not world demand.

Only a few sovereign funds disclose their performance. But it reasonable to think that many sovereign wealth funds – particularly the well-established funds that invested heavily in equities – have had a bad year. Any sovereign fund overweight emerging economy equities – say those who were seduced by talk of a new Silk Road linking the Gulf to Asia – would have done worse. Ask some prominent US institutional investors.

Indeed, the United States Social Security Trust Fund likely has outperformed most sovereign funds over the past few years. The Social Security Trust Fund invests in nothing other than US Treasuries. That currently looks to have been a good choice. An enterprising Norwegian journalist supposedly has calculated that Norway would be better off now if it had just put all its spare oil revenue in the bank.

The fall in equity markets this fall implies that sovereign wealth funds now likely manage far less than $2 trillion in foreign assets. We don’t know how much sovereign funds had at their peak — in part because there isn’t a consensus on what constitutes a sovereign fund and in part because key funds don’t disclose much. And we don’t know how much they have now. But if funds that have been managed by central banks and invested fairly conservatively (Russia’s future fund as well as the non-reserve foreign assets of the Saudi Monetary Agency) are excluded, the size of the external portfolio managed by sovereign funds likely fell this year. Sovereign funds received large inflows in 2006, 2007 and the first half of 2008 – high oil prices increased inflows into many existing funds and new countries created funds.

Norway offers a case in point. I think it had around $380 billion in assets earlier this year. It now has around $300 billion. Norway has more exposure to Europe than most funds, so it has been hurt by the euro’s fall against the dollar. But it also has a relatively high share of its assets in bonds, which helped. It probably isn’t atypical.

The confluence of four trends suggests that the sovereign wealth fund moment has passed – at least for the time being.

— One, sovereign funds are fundamentally vehicles for investing government funds in equities and equity markets have not performed well. Nor for that matter have many “alternative investments.” Hedge fund returns have been not been great – and have been correlated with the equity market. Private equity is still “equity.” I would guess that London real estate isn’t doing that well these days.

Some countries with sovereign funds are subject to democratic pressure and it isn’t clear that there is still consensus in those countries to put public money at risk of (further) large losses. Korea is the most obvious example. Norway’s fund argues that the fall in equity markets provides an ideal time to rebalance Norway’s portfolio toward equities. Perhaps. I will be interested to see if the formal release of Norway’s third quarter results triggers a debate inside Norway over the wisdom of adding to Norway’s equity exposure. My guess is that Norway hasn’t been able to rebalance its portfolio fast enough to offset the market’s fall, and its “equity’ share is now well below target.

As Calculated Risk notes, before moving to New York I worked for Mr. Geithner at both the Treasury and the IMF. Mr. Geithner was, by the end of the 1990s, in charge of Treasury’s International Affairs division, so almost everyone who worked there — Tim Duy and Nouriel Roubini to name two — also worked for Mr. Geithner. At the IMF, Mr. Geithner encouraged the IMF to pay more attention to balance sheet vulnerabilities — and helped to push a paper I worked on with a group of talented young IMF economists through the IMF’s internal review process.

It consequently is no surprise that I am thrilled that Mr. Geithner looks to be Obama’s choice for Treasury Secretary. I am also pleased that President-Elect Obama also found a way to pull Dr. Summers — a voracious consumer of economic and financial analysis, including economic and financial blogs — into the administration. The current, severe crisis will provide plenty of work for both. Like Noam Scheiber, I hope that the combination of Dr. Summers’ intellectual creativity and Mr. Geithner’s disciplined analysis and political acumen proves fruitful.

I also suspect that Felix is right. The immediate challenge facing Mr. Geithner and Dr. Summers is finding a way to contain the current financial and economic crisis. Citi is a case in point. But once we emerge from the current crisis, the Treasury and Fed will need to build global consensus on how to regulate too-big-to-fail international banks — one that balances the world’s need for a banking system that lends with the need for banking system that doesn’t take on too much risk in good times, leaving taxpayers with the bill in bad times.

I know from experience that Mr. Geithner puts a great deal of effort into his (relatively infrequent) speeches. Those looking for insight into Mr. Geithner’s world view could do far worse than to start by picking out a few of his majorpolicyaddresses over the past few years and tracing the evolution of his thinking.

Back when I worked for Nouriel I often posted detailed commentary on Mr. Geithner’s speeches.

Ok, the Treasury can not borrow for free. Three month Treasury bills, according to Bloomberg, yield something like 2 basis point.

Treasury yields aren’t hard to calculate. But they are still my favorite indicators of the scale of the current crisis. The fact that so many are willing to lend so much to the US Treasury for so little is a clear indicator of a lack of confidence in other financial asset. Dr. Krugman is right. Market analysts are more or less saying the same thing: ““Where the credit markets are trading, it’s all but implying a 1929 scenario,” said Joe Balestrino, fixed income strategist at Federated Investors”

I can not match John Jansen’s market experience — but I share his amazement at the scale of the moves in the Treasury market today. Jansen:
The Long Bond is trading at a yield of 3.43 percent and the dollar price has exploded 9 points today. I have done this for nearly 30 years. I have never witnessed this before.

The rise in the price of the ten year bond wasn’t quite as dramatic, but the rise in price (and fall in yield) still shows up quite cleanly.

Suffice to say that surge in Treasuries — and rise in credit spreads — isn’t a good sign. Investors (including central banks) aren’t willing to accept anything that just has an implicit government guarantee — let alone debt with real risk. Right now they want nothing less than the full faith and credit of the US government.

p.s. I would be interested to hear a true believer in the efficient market hypothesis explain recent moves in 30 year swap spreads. For a primer, read Jansen.

Doubts remain about the health of key financial institutions — in large part because they extended a lot of credit against homes and kept far more of that credit on their balance sheets than most analysts expected (and certainly seem to have been more exposed than their regulators realized).

Many emerging economies that previously borrowed a lot now cannot borrow. They will have to cut back. That includes previously high-flying emerging economies like Dubai.

Economic activity is slowing globally — and the risk is that will slow more.

Let me give credit to Dr. Roubini (my former boss) for holding firm to his conviction that vulnerabilities were building even as it seemed, at least for a while, that the US economy would be able to shrug off a fall in investment in new homes.

This is an example of what Calculated Risk calls cliff-diving. Foreign demand for any US bond with a smidgen of credit risk has disappeared. Indeed, the fall in demand for Agencies over the past three months is more severe than the fall in demand for US corporate bonds (think securitized subprime mortgages and other securitized housing and consumer debt) last August.

Normally, this kind of fall-off in foreign demand would be associated not just with a credit crisis but also with a currency crisis. A country cannot finance a trade and current account deficit without financing, and two big sources of financing for the US deficit — foreign purchases of Agencies and foreign purchases of US corporate bonds — have disappeared. The US, though, isn’t a normal country. The fall in demand for risky US assets was offset by a rise in demand for Treasuries and the sale of foreign assets by Americans.

The numbers here are striking. In September, China bought nearly $40 billion of short-term Treasury bills ($39.3b). Foreign banks (there is a small risk of double counting, as this could include Chinese banks) bought nearly $60b of t-bills ($58.8b). Americans sold $35b ($35.4b) of foreign assets. All told, the US sold $111 billion of Treasuries to foreign investors in September — throw in the sale of foreign bonds by American investors you get a net inflow of $146b. That is more than enough to cover the deficit. Indeed, it goes a long way to making up for last month’s financing short-fall. (all data comes from the Treasury)

Because most private purchases of long-term Treasuries and Agencies have been revealed to be — in the course of time — official purchases, I generally add all long-term Treasury and Agency purchases to recorded short-term official purchases of Agencies to get a measure of official flows. This data clearly shows a massive shift from Agencies to Treasuries.

To complete the picture I added short-term t-bill purchases by private investors to the long-term purchases and short-term official purchases. Total Treasury purchases over the last 3 months totaled $214 billion. That’s huge.

The G-20’s ability to reach agreement on a detailed work program on regulatory reform – just think, the US President has signed off on an effort to evaluate whether compensation practices in the financial sector contributed to excessive risk taking — presumably reflects the groundwork done by the Financial Stability Forum. Many of the G-20’s proposals reflect reforms that key countries have already agreed on there.*

It also reflects another reality: agreement on regulatory changes only required a deal among the G-7 countries, not a deal between the G-7 and the emerging world. The big internationally-active banks are still primarily in the US, Europe and Japan – and are still regulated (and bailed out) by these countries. Emerging economies of course feel the impact of a fall in lending if the financial sector in the US and Europe is hobbled – so they aren’t just bystanders. They should want the US and European regulators to do their jobs effectively, so they aren’t sideswiped by a sudden fall in lending. And no doubt regulation in the emerging world is influenced by practices in the US and Europe. But most emerging market banks already held a bit more capital than US or European banks, as the emerging world didn’t bet on the notion that the fall in macroeconomic and financial volatility associated with the “Great Moderation” was permanent. The Great Moderation never really made it to most of the emerging world: they had a lot more recent experience with macroeconomic volatility.

The “regulatory” deal consequently hinged far more on the US and Europe than the emerging world. And they stepped up. I was struck by how robust the G-20 language describing the short-comings in the advanced economies financial systems was. The G-20 leaders:

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

But I was also struck my how quiet the G-20 was on the macroeconomic imbalances that facilitated the expansion of leverage in the US and Europe. Remember, the US had a low savings rate – and required inflows from the rest of the world. If those inflows had fallen off as US household debts – and the financial sector’s balance sheet leverage – increased, the US might not have dug itself into a hole. The communiqué language here was remarkably diplomatic. No mention was made of macroeconomic imbalances across countries – or misaligned exchange rates. The communique language remained very vague: “Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes.” I consequently am surprised (or perhaps I should say less than impressed) that the White House believes that the G-20 reached “a common understanding of the root causes of the global crisis.” Paulson was quite clear on Thursday that the macroeconomic imbalances the G-20 avoided mentioning had something to do with the current mess.

A global slowdown — likely a severe global slowdown — is now underway. Last week’s data erased any real doubt. US retail sales are down. US real goods exports fell in September, and the October ports data (and woes with trade finance) suggest that hope isn’t on the way. The dollar’s rally also won’t help — but that will only hit with a lag. Europe is slowing. Britain is slowing far more. And China is too.

Wang Tao of UBS argues — I suspect correctly — that the weak data on industrial production stems more from a fall in domestic activity, especially a fall in construction that reduced demand for steel and cement, than from a fall in exports. But if the polls on Americans holiday purchasing plans are accurate, exports are going to fall sharply. And this time it won’t just be the garment and toy factories that feel the pain; some of China’s newer export sectors (the ones that have kept y/y nominal export growth at 20% … ) will slump too.

It isn’t a pretty picture. But if nothing else it clarifies the need for strong policy action to offset what now looks to be a sharp and quite sudden fall in private demand.

The Fed’s balance sheet isn’t any prettier. Week after week it continues to expand. As jck of Alea notes, the Fed’s leverage ratio puts Goldman Sachs and Morgan Stanley to shame. Of course, the Fed could always get more capital if it needed it. But the rise in the Fed’s leverage illustrates how it has facilitated the deleveraging of other parts of the financial sector. If it hadn’t acted, things could be worse. Really.

And for all the talk of how foreign central banks are intrinsically stabilizing forces in the market, the real heavy lifting has all been done by the Fed (with a bit of help from the Treasury). The world’s reserve managers may have been a stabilizing force in the currency markets in the third quarter — we will have to see what the IMF’s COFER data tells us (and read the tea leaves to guess what China has been doing; to stabilize the market it should be stepping up its purchases of euros, pounds and Australian dollars … ). But they clearly haven’t been a stabilizing force in the US credit market. In the first two weeks of November they added over $30 billion to their Treasury holdings at the New York Fed while continuing to scale back their Agency holdings. Paul Swartz of the Council’s Center for Geoeconomic Studies (check out its coverage of the Leaders 20) and I tried to illustrate how the Fed has been taking on credit risk even as other central banks have pulled back.

For the US trade deficit to fall (setting the effect of falling oil prices aside), exports have to grow faster than imports — or imports have to fall faster than exports.

If exports fall faster than imports, the deficit will stay large.

In September, the headline deficit fell because the petrol deficit fell. The petrol deficit has gone from $43 billion In July to $35.6b in August and $32.1b in September as the average price of imported oil fell from $125 a barrel to $108 a barrel. That alone generated a $10 billion improvement in the trade balance — and there is more good news to come. Especially if the US continues to import 5% less oil even after the prices come down.

But the non-petrol goods deficit is now moving in the wrong direction. It increased from $29.3b in June to $35.6b in August. Non-petrol exports fell by $9.9b over the last two months, while non-petrol imports fell by “only” $3.7 billion. The sharp fall in exports shows up clearly in a chart showing “real” non-petrol goods exports and imports. Real data tries to show what is happening if changes in price are taken out of the equation — it is meant to measure the actual quantity of stuff that is traded.

The fall in real goods exports has been steep enough to push the real non-petrol trade deficit back up.

And remember this is the September data. Since then the global outlook has deteriorated — and the dollar has strengthened substantially. That isn’t going to help US exports. The main reason why the US should support more emergency lending to the worlds’ emerging economies is pure self-interest: if their currencies continue to fall, the US isn’t going to be able to rely on exports to help it get out its own domestic troubles.

China has just increased its tax rebates on exports. While steps to support domestic Chinese demand help the world economy, steps by China – the country in the world with the largest current account surplus and (on a backward looking basis) still quite rapid export growth – to keep its exports up don’t.

Global demand is falling (Intel, Best Buy, Department stores sales are all telling the same story … ). Big importers can increase their market share through protectionism. Big exporters can increase their market share through export subsidies. Neither helps to address the real problem – the global shortfall in demand.

Monday’s excellent FT leader effectively argues — diplomatically — that the United States isn’t the only country that has lost a bit of economy and financial credibility over the past few years. It turned out that the US credit crisis wasn’t nearly as contained as the Fed and Treasury thought. And it turns out that the TARP isn’t really going to be used to buy troubled assets. But it also turned out that China never really carried through on its 2004 and 2005 and 2006 and even 2007 rhetoric that it planned to rebalance its economy.

Back in 2004 China’s leaders generally got the benefit of the doubt. Not necessarily about the quality of China’s economic data; as David Pilling notes, China’s data never has been all that credible. But most observers expected that China’s leaders would be able to deliver when they announced their plan to shift the basis of China’s growth away from exports and investment. Chinese policy makers generally had a pretty good track record of doing what they said they would do.

But four years after China indicated that it wanted to rebalance its economy, its economy looks more unbalanced than ever – its current account surplus is far far larger than in 2004, and investment accounts for a higher share of GDP than in 2004. The FT:

China’s growth to date has been phenomenal, but it was based on exports and investment, at the expense of consumption. China almost aimed to be a supersized South Korea: in 2005, capital investment made up more than half of China’s gross domestic product. The capital-intensity of its growth also meant profits grew strongly as a share of GDP. But employment growth has slowed since the 1980s, so workers have gained small benefit.
With an undervalued renminbi also making imports dear, the Chinese public has proved loath to spend. China has far too little dom­estic consumer demand. Where­as household consumption made up more than half of China’s GDP in the 1980s, it now contributes little more than a third.

In the absence of a domestic safety net, Chinese household savings have been as high as a quarter of disposable income. In addition, corporate and government savings have soared. Overall, China has been saving close to 60 per cent of GDP. This contributed hugely to the global savings imbalance. Some of the deepest roots of the current crisis lie in the plugging of western deficits with Asian savings.

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